Over & Under Capitalization - Financial Planning and Administration, Business Economics & Finance | Business Economics & Finance - B Com PDF Download

The term capitalisation, or the valuation of the capital, includes the capital stock and debt. According to another view it is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligations which may represent wholly fictitious values.

The ordinary meaning of capitalisation in the computation appraisal or estimation of present value. This ‘valuation’ concept underlies the definitions of capitalisation and the emphasis is placed upon the amount of capital. But the term capitalisation has on thrown its previous concept.

Originally, it was used in the sense of ‘valuation’ and ‘amount’ but qualitative connotation now usually accompanies the quantitative expression. The term capitalisation is now taken as being synonymous with capital structure or financial plan.

The study of capitalisation involves an analysis of three aspects:

i) amount of capital

ii) composition or form of capital

iii) changes in capitalisation.

Capitalisation may be of 3 types. They are over­ capitalisation, under capitalisation and fair capitalisation. Among these three over capitalisation is likely to be of frequent occurrence and practical interest.

Over Capitalisation:

Many have confused the term ‘over-capitalisation’ with abundance of capital and ‘under-capitalisation’ with shortage of capital. It becomes necessary to discuss these terms in detail. An enterprise becomes over-capitalised when its earning capacity does not justify the amount of capitalisation.

Over-capitalisation has nothing to do with redundance of capital in an enterprise. On the other hand, there is a greater possibility that the over-capitalised concern will be short of capital. The abstract reasoning can be explained by applying certain objective tests. These tests require the comparison between the different values of the equity shares in a corporation. When we speak in terms of over-capitalisation we always have the interest of equity holders in mind.

There are various standards of valuing corporation or its equity shares:

Par value:

It is not the face value of a share at which it is normally issued, i.e., at premium nor at discount, it is static and not affected by business oscillations. Thus it fails to reflect the various business changes.

Market Value:

It is determined by factors of demand and supply in a stock market. It is dependent on a number of considerations, affecting demand as well as supply side.

Book Value:

It is calculated by dividing the aggregate of the proprietary items – like share capital, surplus and proprietary reserves – by the number of outstanding shares.

Real Value:

It is found out by dividing the capitalised value of earnings by the number of outstanding shares. Before the earnings are capitalised, they should be calculated on an average basis. It may be pointed out at this place that longer the period cover by the study, the more repre­sentative the average will be the period should normally cover all the phase of business cycle, i.e., good, bad, and indifferent years. Some authors compare the par value of the share with the market value and if par value is greater than the market value they regard it as a sign of over-capitalisation.

Par value > Market value

The comparison of book and real values of shares is a better test in the sense that the book value gives an idea about the company’s past career i.e., how it had fared during the last few years, and its strength is determined by its reserves and surplus.

Real value is a study of the working of company in the light of the earning capacity in the particular line of business. It takes into account not only the previous earnings or earning capacity of a concern but relates the earnings to the general earning capacity of other units of the same nature. It is a scientific and logical test.

Book Value = Real Value (Fair capitalisation)

Book Value > Real Value (Over-capitalisation)

Book Value < Real Value (Under capitalisation)

Causes of over-capitalization:

The following are the cases for over-capitalisation:

i) Promotion with inflated asset:

The promotion of a company may entail the conversion of a partnership firm or a private company into a public limited company and the transfer of assets may be at inflated prices which do not bear any relation to the earning capacity of the concern. Under these circumstances, the book value of the corporation will be more than its real value.

ii) The incurring of high establishment or promotion expenses (ex: good will, patent rights) is a potent cause of over-capitalisation. If the earnings later on do not justify the amount of capital employed, the company will be over-capitalised.

iii) Inflationary conditions:

Boom is a significant factor for making the business enterprises over-capitalised. The newly started concern during the boom period is likely to be capitalised at a high figure because of the rise in general price level and payment of high prices for the property assembled. These newly floated concerns as well as the reorganised and expanded ones find themselves over-capitalised after the boom conditions subside.

iv) Shortage of capital:

The shortage of capital is also a contributory factor of over-capitalisation, the inadequacy of capital may be due to faulty drafting of the financial plan. Thus a major part of the earnings will not be available for the shareholders which will bring down the real value of the shares.

v) Defective depreciation policy:

It is not uncommon to find that many concerns are over-capitalised due to insufficient provision for depreciation/replacement or obsolescence of assets. The efficiency of the company is adversely affected and it is reflected in its reduced profit yielding capacity.

vi) Liberal Dividend Policy:

If corporations follow liberal dividend policy by neglecting essential provisions, they discover themselves to be overcapitalized after a few years when book value of their shares will be higher than the real value?

vii) Taxation Policy:

Over-capitalisation of an enterprise may also be caused due to excessive taxation by the Government and also their basis of calculation may leave the corporations with meagre funds.

Effects of over capitalisation:

Over-capitalisation affects the company, the shareholders and the society as a whole. The confidence of Investors in an over-capitalised company is injured on account of its reduced earning capacity and the market price of the shares which falls consequently. The credit-standing of a corporation is relatively poor.

Consequently, the credit-standing of a corporation is relatively poor. Consequently, the company may be forced to incur unwieldy debts and bear the heavy loss of its goodwill In a subsequent reorganization. The Shareholders bear the brunt of over capitalization doubly. Not only is their capital depreciated but the income is also uncertain and mostly irregular. Their holdings have little value as collateral security.

An over-capitalised company tries to increase the prices and reduce the quality of products, and as a result such a company may liquidate. In that case the creditors and the Labourers will be affected. Thus it leads to the mis­application and wastage of the resources of society.

Corrections for over-capitalisation:

Overcapitalization can be rectified if the following steps are taken:

1. Reorganisation of the company by selling shares at a high rate of discount.

2. Issuing less interested new debentures on premium in place of old debentures.

3. Redeeming preference shares carrying high dividend

4. Reducing the face value (par value) of shares.

Under-Capitalisation:

Generally, under-capitalisation is regarded equivalent to the inadequacy of capital but it should be considered as the reverse of over-capitalisation i.e. it is a condition when the real value of the corporation is more than the book value.

The following are the causes for under-capitalization:

1. Underestimation of earnings:

Sometimes while drafting the financial plan, the earnings are anticipated at a lower figure and the capitalisation may be based on that estimate; if the earnings prove to be higher the concern shall become under-capitalised.

2. Unforeseeable increase in earnings:

Many corporations started during depression find themselves to be under-capitalised in the period of recovery or boom due to unforeseeable increase in earnings.

3. Conservative dividend policy:

By following conservative dividend policy some corporations create adequate reserves for depreciation, renewals and replacements and plough back the earnings which increase the real value of the shares of those corporations.

4. High efficiency maintained:

By adopting ‘latest techniques of production many companies improve their efficiency. The profits being dependent on the efficiency of the concern will increase and, accordingly, the real value of the corporation may exceed its ‘book value’.

Effects of under-capitalisation:

The following are the effects of under-capitalisation:

1. Causes wide fluctuations in the market value of shares.

2. Provoke the management to create secret reserves.

3. Employees demand high share in the increased prosperity of the company.